Large banks have grown and become more involved in market-based activities since the late 1990s. This column presents evidence that large banks receive too-big-to-fail subsidies and create systemic risk, whereas economies of scale in banking are modest. Hence, some large banks may be ‘too large’ from a social perspective. Since the optimal bank size is unknown, the best policies are capital surcharges and better bank resolution and governance.

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Large banks have grown significantly in size and become more involved in market-based activities since the late 1990s. Figure 1 shows how the balance-sheet size of the world’s largest banks increased two- to four-fold in the ten years prior to the crisis. Figure 2 illustrates how banks shifted from traditional lending towards market-oriented activities.

Source: Bankscope, World Bank Financial Development and Structure Database, and authors’ calculations.Note: The loan-to-asset and non-interest income ratios are computed as the average across the four largest banks in each country.

Also, large banks appear to have a distinct, seemingly risky business model. They tend to simultaneously have lower capital (Figure 3), less stable funding (Figure 4), more market-based activities (Figure 5), and be more organisationally complex (Figure 6), than smaller banks.

Source: Bankscope and authors’ calculations.Notes: Data for 2011. Assets are in log billions of US dollars (log assets = 2 corresponds to $7.4 billion, log assets = 5 to $148 billion). Number of subsidiaries is in log (1 + number of subs.).

Systemic risk

In addition to the concerns about large banks’ individual risk, our recent study (Laeven et al. 2014) finds that large banks create most of the systemic risk (i.e. scope for negative externalities to the rest of financial system and the real economy) in today’s financial system.

We investigate whether bank size, involvement in market-based activities, and organisational complexity affect bank risk, and whether bank size interacts with bank capital and funding to influence bank risk. We measure individual bank risk using bank stock returns during the recent financial crisis, and the bank’s contribution to systemic risk using the SRISK measure of Brownlees and Engle (2012) and Acharya et al. (2012). SRISK captures expected bank capital shortfall in a financial crisis, that is, the bank’s contribution to how deep a crisis would be. The study uses data on 370 listed banks from 52 countries, covering effectively the whole universe of listed banks with assets in excess of $10 billion.

We find that:

Large banks are riskier than smaller banks, and create more systemic risk, especially when they have insufficient capital or unstable funding.

Large banks also create more systemic risk (but, interestingly, do not become riskier) when they engage more in market-based activities or are organisationally complex. The intuition here is that market-based activities affect the correlation of bank risk with that of the market, but not bank risk per se.

Too-big-to-fail and empire building

Why do banks become large and risky?

Too-big-to-fail subsidies.

The perception that creditors of large banks will be bailed out during bank distress makes the cost of debt for large banks lower and less risk-sensitive than for smaller banks. This predisposes large banks to use leverage and unstable funding, and to engage in risky market-based activities. GSFR (2014) estimate that too-big-to-fail subsidies reduce the cost of debt for large banks’ debt by about 25 basis points on average through the cycle, with larger gains for riskier banks.

Possible empire building.

Large and market-oriented banks are complex enterprises, fundamentally difficult for outsiders, or even insiders, to understand and control (Mehran et al. 2011, Ellul and Yerramilli 2013). This entrenches managers and reduces the effectiveness of boards, as they may lack the ability to assess the riskiness of the bank’s activities. One way to illustrate this is to note that large banks have a relatively high dispersion of analyst earnings forecasts (Laeven et al. 2014), suggesting that they are complex and/or opaque.

Economies of scale.

Early studies found that economies of scale in banks disappear after the first $50 billion in assets (Benston et al. 1982, Berger and Mester 1997, Peristiani 1997). Recent studies show that economies of scale also exist for larger banks, and are $16–$45 billion per year for the US banking system (Kovner et al. 2013, TCH 2011).1 This is about 0.2% of the $20 trillion size of the US banking system. But about a third of these economies realises in riskier capital-market activities of banks. So the risk-adjusted economies of scale may be less than 0.2%. (Note also that, from the perspective of economic efficiency, the economies of scale pale in comparison to the estimated $6–$12 trillion cost of the recent financial crisis – see Luttrel et al. 2013.)

Overall, the too-big-to-fail subsidies, at 0.25% of assets, appear more important in driving bank size than the economies of scale, at less than 0.2% of assets. Adding possible empire-building incentives would reinforce the conclusion that bank size responds to inefficient private incentives more than to economies of scale. That is, banks seem to become large, at least on the margin, for the ‘wrong’ reasons.

Are banks ‘too large’? Maybe, maybe not

Taking together the evidence that, in choosing their size, large banks respond to inefficient too-big-to-fail and empire-building incentives, and as a result create systemic risk, suggests that large banks may be ‘too large’ from a social welfare perspective.

However, there are two important caveats. First, economies of scale, while probably second-order, cannot be neglected. Second, more critically, the literature is mute about the value that large banks bring to their customers (large global corporations). If banking is contestable, this value would not be part of bank profits (or measured economies of scale). Since we cannot assess the value that large banks bring to their customers, we cannot establish optimal bank size. (This also implies that any outright restrictions on bank size or activities may be imprecise and costly.)

Best policy: Capital surcharges, resolution, and governance

The evidence presented in our paper has useful implications for policy towards large banks.

We need systemic risk-based regulation of large banks.

Traditional micro-prudential regulation, which focuses on individual bank risk, is insufficient to deal with large banks. First, it may not fully reflect the systemic ramifications of large banks’ risk-taking, since the same capital or funding deficiencies create more systemic risk when they occur in large banks. Second, it may neglect the distortions associated with large banks’ involvement in market-based activities or organisational complexity, since they increase systemic but not individual bank risk.

Regulation may take the form of capital surcharges on large banks, in line with Basel III.

Our analysis allows us to quantify the effectiveness of capital surcharges. For example, for a large bank with about $1 trillion in assets, an increase in the capital ratio by 2.5 percentage points (similar to the systemic surcharge in Basel III) reduces its systemic risk by a quarter. If that increase in capital is combined with measures to bring the bank’s involvement in market-based activities, funding structure, and organisational complexity in line with those of medium-sized banks (should this be possible), the systemic risk is reduced by another quarter.

The benefits of higher capital should be traded off with its costs, which appear modest in steady state, but high for rapid upwards adjustments of capital (Ratnovski 2013). There is also a concern that capital surcharges on large banks may push risks to less regulated parts of the financial system or onto smaller banks. But to an extent that risky market-based activities require economies of scale (that is why they occur in large banks in the first place), such a migration of risk is less likely than some may worry.

Better resolution and governance.

It is important to supplement policies that correct market failures (capital surcharges) with policies that aim to eliminate market failures in the first place. These include better resolution to reduce too-big-to-fail distortions (FSB 2011, Dell’Ariccia and Ratnovski, 2013) and better corporate governance for large banks (measures to reduce organisational complexity and high-powered incentives that encourage excessive risk-taking, and measures to strengthen risk controls – see Laeven 2011).

Disclaimer: The views expressed are those of the authors and do not represent those of the IMF.

THC (The Clearing House) (2011), “Understanding the Economics of Large Banks”, November.

Wheelock, D C and P W Wilson (2012), “Do large banks have lower costs? New estimates of returns to scale for US banks”, Journal of Money, Credit and Banking, 44(1): 171–199.

1 Some papers find larger economies of scale, around $70 billion a year (Wheelock and Wilson 2012, Hughes and Mester 2013). However, these should be taken with caution as they are based on debatable assumptions. For example, the ‘ability’ of large banks to operate with lower equity or to engage in risky market-based activities is interpreted as a superior input/output mix, rather than as a riskier strategy.